Netflixed

by Gina Keating

  As Randolph negotiated salaries and perks for his new team, the Pure Atria and Rational Software boards hammered out the terms of the merger. The deal, announced on April 7, 1997, called for a stock swap worth about $850 million—the largest merger in Silicon Valley history.

  Hastings and the Pure Atria board had decided rather abruptly to sell in late 1996, after sales unexpectedly fell short of Wall Street forecasts, potentially exposing the company to a stock price collapse. Pure Atria had rebuffed Rational’s previous merger offers, but this time Hastings and his board of directors decided to accept.

  Although the deal’s final value dropped to $585 million, Hastings suddenly was an extremely wealthy man and a hero to the venture capitalists he had enriched in the deal.

  • • •

  CHRISTINA KISH GOT to enjoy her plush corporate office, with unaccustomed perks like espresso machines and dry cleaning pickup, for five days. Randolph called her at home the following Sunday. He told her they would both lose their jobs as soon as federal antitrust regulators approved the merger. He laid Smith off her first day on the job.

  They all had a four-month grace period, during which Pure Atria paid them simply to show up at the Sunnyvale offices while the companies waited for regulatory approval. Smith worked on a couple of product rollouts. Randolph and Kish showed up each day and sat in their offices without much to do. But Randolph had a large whiteboard, a fast Internet connection, and the beginnings of an idea for a company.

  After joining Pure Atria, Randolph started commuting over the mountains into Sunnyvale with Hastings and, occasionally, other company executives—a trip of an hour each way over winding, narrow, and often traffic-clogged Highway 17.

  On these drives he and Hastings began talking about what they would do when the merger was completed and they were free. Hastings wanted to get his master’s degree in education and put some of his new millions into educational philanthropy to try to revive California’s moribund public school system.

  Randolph revealed his plan to start a company and said he had gotten no further than deciding it would sell something over the Internet. He had watched e-commerce develop with growing excitement and knew that his entire life had led him to this opportunity.

  Marc Bernays Randolph grew up privileged in the leafy New York suburb of Chappaqua, the eldest son of an Austrian-born nuclear engineer turned investment adviser, Stephen, and a realtor, Muriel, who was born in Brooklyn’s Flatbush neighborhood. Stephen Randolph was proud to be the great-nephew of psychoanalysis pioneer Sigmund Freud but spoke less of another famous uncle, Edward Bernays, the father of modern public relations, who used Freud’s theories, at times to devastating effect, in propaganda campaigns for powerful clients such as American Tobacco, United Fruit, and the U.S. government.

  Bernays’s signature accomplishment was unleashing people’s unconscious desires—for love, respect, sex—and using them to mold modern American consumers. Like Bernays, Marc Randolph would obsess over how to use product messaging to entice consumers to behave in specific ways.

  Two generations after Bernays and his contemporary, Alfred Lee Loomis, set in motion two of the modern era’s most powerful forces—American consumerism and high technology—Randolph and Hastings would combine the two in a venture that showed the reach and profit in harnessing science purely to serve consumers.

  Randolph spent his summers as a teenager at the National Outdoor Leadership School in Lander, Wyoming, and became one of its youngest wilderness guides. The experience of leading trekkers twice his age—making snap decisions based on incomplete information and keeping control of situations even when he had no clue where a trail led—proved to be ideal training for forming tech start-ups.

  In a strange parallel to Bernays, an agriculture major who began experimenting with marketing and public relations as a Broadway show promoter, Randolph discovered his life’s passion during a stint at Cherry Lane Music Company, in a clerical job his father helped him get after he graduated, with a geology degree, from Hamilton College in upstate New York.

  Despite knowing nothing about marketing or direct mail, he was put in charge of Cherry Lane’s mail-order operation. This consisted, in its entirety, of a small order form on the back of each sheet music booklet that customers could return for “a list of more great Cherry Lane songbooks.” Randolph collected the orders from the incoming mail and mailed back the requested items, noting what song booklets prompted the most orders, whether new purchases followed, and the like.

  He found this process fascinating and began tinkering with the order form—its arrangement, color, and size—to try to spur orders. He won permission to create a catalog and try a few mailings and soon realized he needed to learn more about direct marketing. He attended conferences and read whatever he could find about best practices, taking his newly acquired knowledge back to his “laboratory” at Cherry Lane.

  When desktop computers and inventorying software came on the market, Cherry Lane tapped Randolph to help design the programs for a mail-order processing system. Later he designed the specifications for a program to manage Cherry Lane’s customer service and the circulation data for the company’s new music magazine.

  The software added an exciting new dimension to direct marketing—the ability to quickly morph order and renewal form designs and track which approach worked best to attract and retain customers.

  In 1984, he helped found the U.S. version of MacUser magazine, which was brought to the United States by British publisher Felix Dennis and pornography impresario Peter Godfrey to capitalize on the growing consumer interest in PCs. About a year later, Godfrey tapped Randolph to a start a new venture—the computer mail-order businesses MacWarehouse and MicroWarehouse. Randolph chose the product mix, published the mail-order catalogs, and set up the telemarketing sales force.

  Here Randolph learned that overnight delivery coupled with superior customer service translated into increased sales and better retention. He partnered with up-and-coming overnight shipper Federal Express and targeted zero tolerance for shipping errors. At the end of each day his customer service workers called to apologize to people whose orders had not shipped. “Every customer you get, you’re never going to lose them” was Randolph’s mantra.

  Direct mail was as beautiful and elegant to Randolph as mathematics was to Hastings. There’s no middleman in the customer relationship, Randolph told Hastings one day during a drive over the hill. You control the relationship, and if you want it to be perfect, you can make it perfect.

  Randolph knew he had to find a large category of products that were portable and related to an activity that consumers would someday prefer to do online, either because of convenience or better selection. He began bouncing ideas off Hastings each day on their commute.

  Each morning, when they met at the Scotts Valley Medical Clinic parking lot, Randolph would start the ride in his Volvo, or in the backseat of Hastings’s Toyota Avalon (chauffeured by a student who acted as Hastings’s regular driver), by saying, “All right, I’ve got a new one.” He would spend a good part of the drive laying out his plan to Hastings, who would shoot holes in it.

  Early on they considered and rejected the $12.6 billion video rental and sell-through category as a natural equivalent to the $12 billion bookselling industry that was dominated online by Amazon. Neither Blockbuster nor Hollywood Entertainment’s Hollywood Video chain, the two largest U.S. movie rental companies, seemed to have any interest in potentially cannibalizing their brick-and-mortar stores’ revenues to sell or rent movies online. But others, with deeper pockets—maybe even Amazon—would surely decide to sell movies online soon, and shrinking profit margins would force out all but high-volume players. If it was going to work, Randolph knew, he had to do something to differentiate an online Video Business.

  “Operationally, I bet we could do rental. You ship it there and then someone ships it back,” h
e said. They ultimately rejected the idea because of VHS inventory costs of sixty-five dollars to eighty dollars per tape, and because the bulky tapes cost too much to mail back and forth.

  In his research, Randolph learned about an optical media storage format called DVD that movie studios and electronics manufacturers were testing in a few markets and planning to launch later that year. The five-inch disks looked exactly like compact disks. Then they test-mailed one to Hastings’s house and it arrived unscathed a day or two later.

  By this time Randolph and Hastings had started sharing ideas with Kish. One day Randolph called her into his office, where she found Hastings waiting. Alarm bells went off in her head as she sat down and Randolph shut the door. Now what? she thought.

  They told her that Hastings planned to put up $2 million to back Randolph’s e-commerce start-up. They needed help researching which ideas were feasible, and in marketing the new online business. Hastings was giving them six months to get it going—was she in?

  After they settled on renting DVDs by mail, Kish began studying the economics of home entertainment by pulling apart Blockbuster’s and Hollywood Video’s operations and finances. But it was not clear how Blockbuster made money, no matter how she modeled the numbers, after covering its store leases and massive inventory costs.

  They used the whiteboard in Randolph’s office and spent hours plotting how to convince Blockbuster customers to abandon convenient, familiar video stores for a store that existed only in cyberspace. Customers would also have to wait a week to receive their movies. It seemed ludicrous to imagine that they could challenge Blockbuster by manipulating its own model. By examining Amazon, however, they found their selling point: Their company would boast the largest selection of movies on DVD in the world.

  They decided the customer interface had to meld the familiar layout of a video rental store with the pictorial and descriptive come-ons of a catalog to make the merchandise seem worth the wait.

  The ordering process had to be easy; it could not take more steps to choose a DVD online than to pick up a movie from a store and return it.

  Randolph was acutely aware of the importance of engaging consumers’ emotions, and he wanted the site to be a personal experience, as if each customer opened the door to find an online video store created just for him or her.

  In early summer 1997, Hastings urged Randolph and Kish to take the whiteboard musings and develop a business plan for the DVD rental company before someone beat them to it.

  Now officially unemployed after the merger of Pure Atria and Rational, Hastings admitted to being a little depressed that the company he had identified with so closely was now closed to him. He had been accepted to Stanford for graduate education studies and was beginning to get involved in politics, but he wanted to keep his hand in a tech venture in Silicon Valley.

  Hastings recommended a gifted French programmer named Eric Meyer to design and build the Web site, and Randolph brought Te Smith aboard to handle public relations and customer acquisition, as she had done with Lotus 1-2-3 software and for Sidekick.

  The initial company meetings took place at Buck’s Restaurant in Woodside or the Hobee’s restaurant in Cupertino, and then in a dingy conference room in the Best Western in Scotts Valley. The new team first dealt with the nuts and bolts of setting up the company—finding office space and furniture, deciding on benefits, pay, and titles. To Kish, Randolph, Meyer, and Smith, it was thrilling and absurd all at once. Here was a company with which they could test their dreams and ideas, and that they were aiming squarely at the flank of one of the largest U.S. entertainment corporations.

  • • •

  ALTHOUGH THEY WERE long on marketing and software development smarts, they had no experience with movie rental or the entertainment industry. That summer Randolph went looking for some outside expertise at the annual Video Software Dealers Association convention in Las Vegas, an enormous trade show that showcased home entertainment products and VHS releases for movie studios and their natural enemies, home video retailers.

  The studios had long resented the video retailers as interlopers that took no risks yet siphoned off profits from moviemaking through the burgeoning home entertainment category. Home video sales and rental started in 1977, when Magnetic Video founder Andre Blay convinced 20th Century Fox to license fifty titles to him to sell directly to consumers. Blay took out an ad in TV Guide offering the first theatrical motion pictures on home video through his Video Club of America. Even though Betamax and VHS copies of the movies cost fifty dollars apiece, and video players retailed for a thousand dollars, Blay got thirteen thousand responses.

  The high prices put video purchases out of reach of most American consumers, and many merchants balked at the $7.50 licensing fee on each video sale, and at the advance payments required on bulk orders. As a result, mom-and-pop retailers bought copies of the pricey videos from Blay and started their own home video rental businesses. As the prices of players dropped, video clubs sprang up across the country, offering movie lovers their first chance to watch commercial-free movies at home for an annual membership fee plus up to ten dollars a day.

  The studios threatened lawsuits to curtail the rental operations, leading the merchants to form the Video Software Dealers Association in 1981, to lobby against attempts to force them to pay a royalty on each video sale or rental. The U.S. Supreme Court ruled that a 1908 U.S. copyright law, known as the First Sale Doctrine, protected the merchants’ rights to sell or rent videos they owned.

  By 1988, annual video rental revenue had surpassed box office receipts for the first time—$5.15 billion to $4.46 billion. Home video rental was here to stay.

  • • •

  RANDOLPH WANDERED THROUGH aisles of booths of the enormous exhibition hall on the VSDA convention’s final day, a backpack slung over his shoulder, stopping to hear product pitches and soaking in as much information as he could. He stopped at a booth selling software for retail stores to chat with an affable-looking guy with longish hair and a biker-style horseshoe mustache.

  Mitch Lowe owned a ten-store rental chain called Video Droid in northern California’s Marin County, and had just started a side business building Web sites to manage customer databases for video rental stores.

  Over the years the forty-four-year-old Lowe had spent thirteen thousand hours behind the counters at his stores, watching customers surf the aisles and observing what got their attention, what titles they took home, which films were likely to be hits, and how many times he had to turn a VHS tape to make a profit.

  Impressed with Lowe’s deep knowledge of movie rental, Randolph took a card from the counter and asked, “Can I ever call you sometime to ask questions about this business?”

  “Sure, sure,” said Lowe. As Randolph turned to leave, Lowe, on impulse, grabbed his backpack and pulled him back.

  “What exactly are you trying to do?” Lowe asked. They agreed to meet at Buck’s in Woodside a week or so after the show to share ideas and information. Later that day, as Randolph leafed through the trade show program, he saw a photo of Lowe and realized he had been talking to the president of VSDA.

  A placid and sweet-natured man, Lowe was liked and respected enough in the industry to help guide the conversion from VHS to DVD among the rival factions represented by merchants, studios, and video wholesalers.

  The meetings at Buck’s became an almost weekly event that produced the ideas for Netflix’s FlixFinder, a search engine to locate movies by title, actor, or director, and the FilmFacts link to synopses and ratings, and to cast and crew lists and DVD features. Browse the Aisles let shoppers scan lists of movies grouped around a genre or theme or enter a favorite film and be shown similar titles—functions typically performed by a video store clerk.

  Randolph often brought along Kish, and sometimes Hastings, too. He frequently pressed Lowe to join their start-up. Lowe resisted. First, his video s
tores were already taking a backseat to his fledgling Web site building project and VSDA business, and second, his wife, Zamora, and three kids thought the idea of renting movies by mail was a loser.

  But the intersection of retail and technology fascinated Lowe. He had built his own video rental vending machine a decade earlier after becoming fed up with his flaky staff and high store overhead. Lowe installed the kiosk in a Japanese hospital and never made back his investment in it, but the experience had not stopped him from experimenting. In November Lowe realized his software enterprise was going nowhere, and he finally agreed to join Randolph’s still-unnamed company as a video rental domain expert and movie acquisitions chief.

  • • •

  THE ANGEL FUNDS supplied by Hastings and augmented by Randolph’s parents and Integrity QA cofounder Steve Kahn allowed the little company the rare luxuries of office space, regular salaries, benefits, and proper equipment from the beginning. The founding team now numbered eight, with the additions of programmers Vita and Boris Droutman, a young Ukrainian couple recruited by Meyer, and operations and financial director Jim Cook.

  Randolph found a small space once used as a bank branch in an office park off Highway 17 in Scotts Valley. The office had luminous green carpet—they joked it was the color of the money they hoped to make—and a strange, narrow room on one end with an armored door, which Randolph supposed had been used as a vault. It made a perfect space for storing DVDs. He furnished the large central room with rows of long folding tables and cheap desk chairs so that Meyer could buy top-of-the-line computers and costly Oracle software. Randolph claimed one of the tiny offices on the room’s perimeter, installed Smith and Kish in another, and designated a third as a conference room. The servers were installed in a closet. Cook also had a small office, but worked mainly in the vault. The Droutmans and Meyer and their desktop computers occupied the folding tables.